Doubts over Beijing's US$40b bailout

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China's financial authorities appear to be on the verge of another giant banking bailout. This round of bank reforms will be tougher than the last and more expensive but even less likely to succeed in turning state lenders into genuine commercially driven banks.

If the mainland media are to be believed, the central bank is preparing to recapitalise the Agricultural Bank of China with as much as US$40 billion of the country's foreign exchange reserves; meanwhile, it will inject a further US$20 billion of reserves into state policy lender China Development Bank.

If the US$60 billion handout goes ahead as reported, the central bank will be spending as much to recapitalise Agricultural Bank and China Development Bank as it did on the bailouts of China Construction Bank, Bank of China and Industrial and Commercial Bank of China put together. On the surface, the timing seems propitious. Yesterday, Agricultural Bank announced a 65 per cent year-on-year increase in first-half operating income, which rose to 42.3 billion yuan. At the same time, the bank said non-performing loans dropped by 2 percentage points.

But behind the facade, things look ugly. According to the bank's own figures, more than 21 per cent of its outstanding loans, worth about 728 billion yuan, are non-performing.

That leaves the Finance Ministry's 84 billion yuan of equity worthless. But the ministry is loath to surrender control by writing off its entire stake ahead of a central bank capital injection as it did with Bank of China and China Construction Bank. As a result, the restructuring of Agricultural Bank has already been delayed by more than six months as Finance Ministry and central bank officials bicker over the details.

Whatever the final outcome, recapitalising Agricultural Bank will be costly. A back-of-the-envelope calculation indicates the bank needs new capital of about 400 billion yuan, more than US$50 billion, if it is to achieve its desired capital adequacy ratio without drastically shrinking its balance sheet. Some of that might come from foreign strategic investors - Agricultural Bank has been talking to other farmers' banks around the world, including France's Credit Agricole - but inevitably most will have to come from state coffers.

At the same time it will need a separate bailout of about 570 billion yuan, US$75 billion, if it is to reduce its non-performing loans to an acceptable level. The usual way is for a state asset management company to buy the loans at face value, even though they probably are not worth more than 10 to 15 fen in the yuan.

In total then, restructuring Agricultural Bank is likely to cost the state at least 800 billion yuan, more than US$100 billion.

That expense is far from guaranteed to create a well-managed bank, however. During the first half of the year, Agricultural Bank continued to expand its loan book at breakneck pace, extending new loans worth 84 per cent of its official target for the entire year. Even more troubling is the chance of a fresh blowout in the bank's non-performing loan ratio. About 10 per cent of Agricultural Bank's outstanding loans are to intensive energy users or big polluters, magnifying the risk of new defaults should the government crack down on credit to environmentally unsound enterprises or enforce polluter-pays clean-up rules.

Meanwhile, the central bank is also reported to be on the point of injecting US$20 billion into China Development Bank. This is curious, because according to the bank's own figures it is adequately capitalised with a minimal non-performing loan ratio, and in little need of a bailout.

Assuming the bank's figures are accurate, this would imply that China Development Bank is planning to expand its balance sheet massively. Doing so by making new loans at home could be tricky; Beijing is trying to rein in domestic investment not ramp it up. On the other hand, the bank could be planning an acquisition spree abroad. It recently bought a stake in Britain's Barclays Bank for US$3 billion. If the recent reports are correct, it could be getting ready to buy a lot more over the coming months. How about a stake in Bear Stearns?

In total then, restructuring Agricultural Bank is likely to cost the state at least 800 billion yuan, more than US$100 billion